Global Economic Crisis

global economic crisis

Preventing and Responding to the Crisis of 2018 Arvind Subramanian

Looking ahead, the big macroeconomic policy question for India is whether or not it should emphasise greater self-insurance with a necessarily more cautious approach to capital market integration. The serious adverse impact of the current crisis should awaken India to the need for effective self-insurance in the future. If self-insurance becomes an important policy objective, the government will need to revisit its macroeconomic policy, including exchange rate management and capital account convertibility. Self-insurance calls for countercyclical policy – dampening flows and keeping the currency competitive – so that reserves can be built up during good times.

I am grateful to Josh Felman, Olivier Jeanne, Vijay Kelkar, Dani Rodrik and John Williamson for helpful discussions. Arvind Subramanian (asubramanian@ petersoninstitute.org) is with the Peterson Institute for International Economics, Washington DC.

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his crisis is not over, by any means. Drawing lessons is therefore a little premature. The future may yet surprise. With that caveat, policymakers should be rattled enough by the crisis to attempt to draw lessons, albeit provisional/ interim, from it in thinking about p­reventing and responding to the next c­risis – the crisis of 2018. What has come as a genuine surprise is the impact on India – on the financial side – of this crisis compared with that of the Asian financial crisis (AFC) of the late 1990s. Stock prices have declined by nearly 40% and the exchange rate decline of about 25% would have been considerably greater but for intervention by the Reserve Bank of India (RBI). This differential f­inancial contagion has stemmed from the simple fact that India has become much more integrated in international capital markets. Net capital inflows reached a peak of over 10% of the gross domestic product (GDP) compared with relatively negligible amounts leading up to the AFC. India may still be relatively closed in p­olicy terms but that has not deterred substantial inflows. In de facto terms, India is no longer a closed economy from the pers­ pective of financial integration. There was surprise on two scores. First, policymakers and market participants u­nderestimated the extent of India’s f­inancial integration: while they were or must have been aware of cumulative nonresident investments in rupee assets, they did not fully grasp the magnitude of foreign funding (liabilities) of Indian financial institutions and corporates, especially those that had borrowed abroad to finance their mergers and acquisitions in the last few years. Second, and perhaps more importantly, they assigned relatively low probabilities to the perfect storm of foreign exchange pressures emanating from so many fronts,

all related to the financial crisis in industrial countries. Deleveraging led to nonresident flight from rupee assets while tightening credit markets abroad forced Indian corporates to turn to the Indian banking system for credit and for rolling over their foreign funding. In the ultimate analysis, this sharply increased demand for foreign exchange – manifested in part and in the first instance as a demand for credit from the Indian banking system – placed considerable pressure on the rupee and the RBI’s foreign exchange reserves. What appeared to be a very comfortable reserve position at the start of the crisis, seemed a little less robust in light of the magnitude of reversal of capital flows. In the event, the rupee depreciated by about 20 to 25% and the RBI lost about $40 to 50 b­illion in reserves over the space of two months. Looking ahead, the big macroeconomic policy question for India is the following: in light of the crisis, should India’s strategy emphasise greater self-insurance, with a necessarily more cautious approach to capital market integration, or does the c­risis point to an even more enthusiastic embrace of foreign capital? There are also other questions relating to fiscal and monetary policies as well as financial sector development that this article will address.

Self-Insurance Self-insurance is not a new idea or policy objective. Implicitly or overtly, and to varying degrees, the east Asian countries made self-insurance an important policy objective after the AFC. But India did not do so in the aftermath of the AFC because it was not seriously affected by it. In terms of highlighting the importance of self-­ insurance, this crisis has done (or should do) to India what the AFC did to the east Asian countries. While the impact of the crisis has been greater than expected, it is undeniable that India’s foreign exchange reserves, helped in limiting this impact. If India had gone into the crisis with $100 billion or even $150 billion of reserves instead of $300 billion, confidence would have been vastly more difficult to manage, in part because foreign exchange intervention january 10, 2009  EPW   Economic & Political Weekly

global economic crisis

could not have been deployed to the same  extent. So, one lesson seems to be that self-­ insurance is a prudent and even necessary strategy to limit the impact of financial crises. This would, of course, have to be qualified if international collective a­rrangements – regional and multilateral – can provide liquidity during crises. There have been some encouraging developments in the recent crisis: the International Monetary Fund has now a quick disbursing facility and the US Federal R­eserve provided dollar liquidity under swap arrangements with four emerging market countries. India should as a res­ ponsible member of the international community work hard towards building these arrangements, but for the foreseeable future, liquidity provision under them is unlikely to become a full or adequate substitute for domestic self-insurance. Moreover, the contrasting experience of China – which experienced limited financial contagion because of its staggeringly large foreign reserves – and the others, even those with large amounts of reserves (such as Russia, Brazil, Korea and India), must give pause. China’s relative immunity seems to lend support to a stronger v­ersion of self-insurance, a kind of Powell doctrine for financial crises: a financial crisis like war requires vast firepower to mount an effective response so that the battle is won even before it begins. If this is true, being prepared for, or minimising the impact of, the next crisis requires large amounts of reserves, perhaps even more than India had at the beginning of this crisis. So, what does Powellian self-insurance imply? In its most extreme form, it implies a counter-cyclical macroeconomic strategy of moderate/serious mercantilism with a country aiming to run current account surpluses in order to accumulate reserves steadily and thereby also keeping its net foreign indebtedness manageably small. It  certainly means avoiding currency a­ppreciation. Two distinctions are necessary. First, self-insurance and building-up reserves relate to net flows but vulnerability to c­rises depends on gross inflows, in fact on gross liabilities. India in this crisis has found itself somewhere between Korea and China. China self insured with a Economic & Political Weekly  EPW   january 10, 2009

vengeance ($2 trillion of reserves) and r­estricted capital inflows. India and Korea had broadly similar and lower l­evels of self-insurance. India, however, had larger levels of gross inflows than China but smaller than those of Korea. The second distinction is between mercantilism and the associated reliance on a competitive exchange rate as development strategy (on which there is a lot of debate) and mercantilism as counter-cyclical macro­economic policy. A self-insurance objective would argue for a certain a­pproach to the capital account and exchange rate to accumulate reserves during good times, with these reserves being used up during times of crisis.

How Much Self-Insurance? This crisis will rekindle debate about how much is adequate self-insurance. The old rules, including the Guidotti rule that reserves should be as much as debt falling due within a year needs to be revisited. A starting point would be to ask: what are the total gross foreign liabilities of all f­inancial and corporates falling due within a 12 to 18 month period. The recent e­xperience suggests that any funding by Indian corporates in foreign capital markets (such as those of the Tatas or even Arcelor­Mittal) should be included in thinking of the optimal size of the war chest. The problem is that one cannot stop there. In the recent crisis non-resident investments in the equity market were also prone to sudden withdrawal. In fact, in the recent crisis, the reversal of these flows were as important as debt rollovers in putting pressures on the currency. It is not obvious why reserves should not cushion against this kind of sudden stop as well. To be sure, there is one difference between foreign portfolio investments in the d­omestic stock market and foreign currency denominated debt. Withdrawals of portfolio investments have a self-limiting aspect to them: prices adjust to moderate outflows. But the recent crisis shows that even if they are self-limiting, the process can easily play itself out enough to create significant pressures on the currency, especially if there have been sizeable cumulative inflows. One could go even further. If there are no capital controls on residents, crises could also lead to pressure on foreign

e­xchange reserves from residents fleeing rupees directly or indirectly through trade channels. Of course, it is not possible for the government to self-insure against all these sources of pressure on foreign e­xchange but prudence would require taking a broader view of vulnerability to c­risis: vulnerability stems not just from foreign-denominated contractual liabilities (i e, debt instruments) but from a much broader class of capital flows. Two conclusions follow: first, effective self-insurance might require a la the P­owell doctrine a sizeable war chest of reserves. To change metaphors a little, one might say that the Chinese experience shows that one should not just save for the rainy day but that to prepare for the d­eluge one should build nothing less than Noah’s ark. Second, the size of the chest will depend directly on how much the country opens itself to capital – gross capital – flows. The more open the capital account, the greater the likely deluge and the b­igger the required ark. Two clear reservations to a strategy of self-insurance must be noted. First, there is a fallacy of composition issue. Mercantilism might work for a few countries but mercantilism by all would lead to beggarthy-neighbour outcomes and international frictions. The first-best of course is the creation of pooled liquidity at international level that could be made easily and quickly available to some or many countries in crisis. If that option is not seriously on the cards – and nothing about the r­ecent crisis will engender confidence that that option is on the horizon – the pursuit of self-insurance by some or many countries will be an unavoidable second-best option, and for countries such as India even a necessary option. The second reservation is at the country level. Self-insurance and the associated mercantilism protects against financial contagion. But this strategy will also increase reliance on exports and foreign markets for sustaining growth. Export-toGDP ratios will increase. A consequence of this is greater vulnerability to trade contagion. If the economies of the United States (US) and the European Union (EU) head into recession, China is more susceptible to a cyclical slowdown because of its greater reliance on exports. So, what a

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global economic crisis

country gains on the swings (protection against financial contagion) it loses partly on the roundabouts (vulnerability to trade contagion). Policymakers will have to trade off these benefits and costs. One a­rgument, of course, is that this susceptibility to a slowdown from declining f­oreign demand can be offset by offsetting policies to boost domestic demand, which China has sought recourse to. But this r­equires a strong sovereign balance sheet.

Sovereign Balance Sheet The one safe conclusion to draw from this crisis is that there will be other crises of similar magnitude in the not-too-distant future. True, it will probably not take the same form, but that there will be a crisis is inevitable. So, what other mitigating strategy apart from self-insurance on the e­xternal side can a country deploy? Crises such as these show that the lender/ guarantor of last/ultimate resort is the government. Governments have to take over often substantial amounts of private sector liabilities in crises and governments have to implement counter-cyclical fiscal policy during steep downturns. The US demonstrated the former; and the Chinese with the huge fiscal effort announced recently have implemented the latter. India has, sadly, not been in a position to easily do either because its sovereign balance sheet is shaky (it has been noteworthy that during this crisis, the brunt of the burden of providing macroeconomic stimulus has been forced upon monetary policy because fiscal policy has been hamstrung by the state of the public finances). For the future, therefore, India should aim for a balance sheet that is robust and sound enough to be able to increase public liabilities by large amounts within a short space of time: say, up to 10%-20% of GDP. The implication is that it is imperative to have India’s debt, during the phase of r­apid growth, to come down to levels from which ramping up of the orders mentioned above will be feasible. This implies a debtto-GDP ratio in good times of no greater than 30%-40% of GDP. Medium-term f­iscal consolidation involving a substantial reduction of public sector indebtedness is an urgent task for the future, once the crisis has passed (during the crisis, some fiscal

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expansion, taking advantage of oil price declines, should not be ruled out).

Foreign Capital Before the AFC, the orthodoxy (Mark I) was to aim for capital account liberalisation. After that crisis, the revised orthodoxy (Mark II) was that countries that had already opened up to capital flows should not reverse policies but that closed or semi-open countries such as India should proceed cautiously on the path of capital account opening e­specially short-term debt flows. But one can detect the emergence of a new view that has not yet attained the status of o­rthodoxy (Mark III) but is garnering more adherents. On this view, not only should those not already open be cautious but even countries that are open should think of careful and prudent ways of managing, even dampening, inflows through policy actions. In the last few years, India has been moving from Mark II to Mark I. It is undeniable that this development – India’s r­apid integration in world capital markets – has been one of the principal reasons for the surprisingly large magnitude of the impact of the crisis on India. Does this impact necessitate a rethink of capital account convertibility? What should India aim for? Capital account convertibility (CAC) has been a hotly debated topic in India and the

subject of three officially-sponsored r­eports: Tarapore II, Mistry and Rajan. One can argue that all of these need to be revisited in light of the crisis for one s­imple reason: none of them addressed directly the question of whether self-insurance against financial crises should be a macro­ economic policy objective guiding CAC. In other words, the issue here is not whether foreign capital is good or bad for India’s growth from a development pers­pective; rather, it is whether the introduction of a self-insurance objective into policy – arguably one of the lessons of this crisis for I­ndia – should alter in any way current macroeconomic policy toward CAC. What follows assumes that self-­ insurance should be an important future objective because that is one of the lessons of the crisis. If that is so, looking ahead, I­ndia faces three options. The first option is to continue the current policy of continuing and accelerating the move toward CAC as argued in the Mistry, and more guardedly in the Rajan Committee, report. It is a necessary consequence of pursuing this option that it would not allow for any serious self-­ insurance and therefore would be based on a relatively sanguine view about the vulnerability to sudden stops and their consequences. This view will necessarily lead to large and sharp swings in asset prices including exchange rates.

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global economic crisis

The second option assumes that sudden stops create large costs and that there is need for substantial self-insurance. This requires preventing the exchange rate from sharp swings, especially appreciation, and which in turn requires being e­xtremely cautious about further CAC and perhaps also requires consideration of prudent, transparent, probably price-based and possibly short-term measures to dampen incremental inflows. The essential logic of this view is that self-insurance requires managing the exchange rate which becomes progressively difficult the greater the capital flows. Put more starkly, this view sees full capital account openness as both increasing the vulnerability to crises (the more the capital that comes in, the more that can exit) and also reducing the ability to respond to c­rises because openness limits the ability to maintain competitive exchange rates and hence build up reserves through current account surpluses. China is very much the model for this option. There is a third view. This view favours capital account opening but also deems self-insurance as important. This is the itis-possible-to keep-the-baby-without-thebathwater view. The challenge for this view is to show how self-insurance and capital account opening can be kept compatible for the duration that is necessary to build-up reserves. Or, how can e­xchange rates be managed and prevented from over-appreciating over long enough periods of time with open capital accounts? Proponents of this view would argue that there is a policy arsenal – comprising sterilisation and counter-cyclical fiscal policy – that can keep CAC compatible with self-insurance. But consider each of these policy measures. Can sterilisation or rather sterilised intervention be effective for managing the exchange rate for long periods of time? China cannot be invoked as the model b­ecause China has managed to sustain sterilisation only because it has been carried out in the context of a relatively closed capital account (that makes sterilisation less self-perpetuating) and financial r­epression (that makes sterilisation less costly fiscally because of the low interest rates). India cannot and should not revert to financial repression. With that constraint, sterilisation becomes unviable Economic & Political Weekly  EPW   january 10, 2009

with an open capital account because steri­lisation by keeping interest rates high perpetuates the inflows, requiring more sterilisation and so on. The other option is to have a fiscal policy that (i) can be tightened, and (ii) tightened quickly enough when the economy overheats from capital inflows and appreciating exchange rates. The Indian experience with fiscal policy, especially with all the complications arising from fiscal federalism, does not offer much comfort that fiscal policy can be an effective countercyclical policy tool. What finance minister can raise taxes or cut expenditures at a time when foreigners are willing to lend so much to a country? In previous episodes of currency appreciation, many have called for structural reform as a competitiveness enhancing measure. Structural reforms are desirable in themselves but they cannot become a tool of counter-cyclical monetary or macro­economic management. Is this discussion of self-insurance and CAC relevant for India? The answer is an emphatic yes. Consider, the likely outlook for reserves, capital flows, and the e­xchange rate, once the crisis has passed.

Target for Self-Insurance India will emerge from the crisis with about $200 billion in reserves. If self-­ insurance is an important new objective, what target level of reserves should India be aiming for say five or 10 years ahead? This question must be faced. Similarly, while currency pressures have been the most significant manifestation of the crisis, the collateral benefit has been to bequeath to India a hypercompetitive exchange rate for after the c­risis. At Rs 50 to the dollar, Indian e­xports will be hyper-competitive, and Indian growth prospects restored to close to precrisis levels of 8 to 9%. At that stage, it is highly probable given significantly h­igher returns in India compared to elsewhere that capital will once again come pouring into India. This outcome is close to inevitable. That is the point at which all the i­ssues raised here of self-insurance, mercantilism, and capital account openness will become relevant. What should India do when the rupee finds itself once again soaring from Rs 50 to Rs 40 to the dollar

within a short space of time? Should India allow that to happen especially if it is aiming for self-insurance reserve levels of say $500 billion or even $1 trillion a few years ahead? That will be the next big policy challenge.

Finance India is still under-intermediated and the Indian financial system is in considerable need of improvement. There are many i­mportant issues relating to financial s­ector reform such as inclusiveness; m­arket and product development; the i­nternational dimension of financial s­ector reforms; and controlling leverage. But it is the international dimension of some aspects of financial sector reform that is most central to the policy questions raised in this note. Take the case of developing the Indian domestic government and corporate bond markets which is an important objective, especially to facilitate the f­inancing of infrastructure. The difficult choice would arise if bond market development were to entail a surge in capital inflows. These flows could create the same consequences for exchange rate a­ppreciation/ self-insurance and be prone to the same sudden stops phenomenon as other port­ folio inflows (say in equity markets). Bond market development may well have positive benefits in terms of mobilising savings and better allocating capital. But if it is associated with significant net inflows (which is likely given higher growth prospects in India) the attendant consequences for vulnerability to crises and attenuated ability to self-insure must also be taken into a­ccount. Will these costs be worth the bene­fits? This cost-­benefit calculus has to be freshly examined in light of the lessons of the current financial crisis. Or, are there intermediate solutions? For example, can India allow foreign players to participate in domestic bond markets without necessarily allowing them to bring in foreign capital? Or, if foreign capital were allowed into domestic bond markets, could there be requirements that they be invested for a minimum period of time (as with say hedge fund investments) or that there be price-based incentives/ taxes to prevent large swings in these flows. Recognising that financial development that leads to surges in foreign capital

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flows is not unambiguously beneficial from a self-insurance perspective is key to the more nuanced and pragmatic thinking that the crisis should motivate. Two final points on CAC. Even those who see the importance of self-insurance and the need to manage inflows argue that technological change and trade integration make capital flows increasingly difficult to control. Surely, some leakage is inevitable but the difficulty of controlling flows is sometimes overstated: in its extreme form it suggests that opening to capital flows will have no effect on actual flows because controls have already been evaded (for example, it is difficult to b­elieve that liberalising bond markets in India and opening them to portfolio inflows will have no effect on actual flows). Even if regulations are difficult to maintain for long periods of time, this should not preclude careful assessment of benefits and costs, taking account of the implementation difficulties. Second, will a cautious approach to CAC send the wrong signals to foreign investors? The Zeitgeist has changed, and the intellectual climate is shifting away from a no-questions-asked-embrace of financial globalisation. In this climate, sensible and pragmatic policies are unlikely to send the wrong signals. Moreover, to the extent that this concern is valid, India can easily counter it by moving faster on opening up its markets to foreign direct investment. The message will be that India is not moving back in terms of its attitude to foreign capital; rather it will be that India recognises, like most countries, that distinctions need to be made between different forms of capital flows based on the experience among others of the recent crisis.

Monetary Policy and Asset Prices We have learnt yet again that asset prices – of stocks, bonds, housing, and exchange rates – that rise very sharply over short p­eriods of time must be carefully watched and responded to. For countries such as India, it is especially important to avoid rapidly appreciating currencies. The stock market bubble of the late 1990s and the housing bubble that led to the current crisis provoked a fierce debate about the appropriateness of policy –

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mone­tary and financial – to respond to sharp asset price increases. Alan Green span f­amously persuaded the world that bubbles could not be easily identified, and hence pricked, ex ante. Far better to pick up the pieces after the bubble had burst. It is fair to say that this asymmetric policy response – the Greenspan put – is being seriously questioned if not discredited. Monetary and financial authorities must be vigilant when asset prices rise sharply, and deviate from some broadly sensible norm; and depending on context, must use monetary policies and/or prudential policies to, yes, prick them. If sharp increases in asset prices are concentrated in some sectors, directed prudential policies (greater provisioning; higher margins, tighter capital adequacy standards, etc) will be called for. If, however, i­ncreases in asset prices are more broadbased and related to credit expansion more generally, tightening monetary policies should remain an option. Central bankers should abundantly combine paranoia and puritanism: paranoia about any sharp increases in asset prices, and puritanism in taking away the punch-bowl (by tightening prudential and monetary policies) to prevent the bubble from becoming intoxicating. Policy should strive to be as anti-cyclical as good judgment and common sense will allow, and hence more symmetric than Alan Greenspan argued for. He wanted to focus on addressing the hangover. The crisis suggests that his successors should also strive to limit drunkenness. A related consequence for monetary policy is in the area of inflation targeting. There are calls in India for the RBI to focus on inflation as a near-exclusive objective. This is not the time to debate the merits of inflation targeting. But the crisis has thrown up a new reality. In the presence of a crisis, the US Fed has behaved as if it has not one (inflation) not two (inflation and growth) but three mandates (inflation, growth and financial stability). Stephen Roach of M­organ Stanley has called for an explicit codification of this triple mandate for the US Fed. Indeed, in the current crisis, deflation-cum-financial-distress is nudging central banks towards a “credibly irresponsible” abandonment of the traditional inflation objective. They are, not inappropriately,

debauching not preserving the currency. It is inevitable that preserving financial sector stability will be an important objective for India too. Setting up a legal framework with a formal, and somewhat rigid, adherence to one objective seems to run counter to the sensible behaviour that c­entral bankers have exhibited during the recent crisis. Moreover, if the crisis leads to self-­insurance becoming an important objective of economic policy, it will be hard for monetary policy not to keep an eye on the exchange rate as it strives to f­acilitate the amassing of the required levels of reserves in the future. The crisis has shown that leverage is perhaps the original sin of finance. India is still under-intermediated but leverage in the financial and non-financial sectors should be closely monitored and regulated, with a particularly watchful eye on rapid increases in leverage. For banks, and all f­inancial institutions, there should be direct limits on leverage in addition to any future Basel II-type capital adequacy r­equirements.

Conclusions India did not focus on self-insurance after the AFC of the 1990s b­ecause it was then closed to capital and hence relatively unaffected by that crisis. This crisis has been very different. Its serious adverse impact should awaken India to the need for effective selfinsurance in the future. If self-insurance becomes an important policy o­bjective, India will need to revisit macro­economic policy, including exchange rate management and capital account convertibility. Put starkly, self-insurance calls for counter-cyclical p­olicy – dampening flows and keeping the currency competitive – so that reserves can be built up during good times. More broadly, on a host of issues, from capital account convertibility, exchange rate flexibility, financial sector development, and inflation targeting, the intellectual climate in India was increasingly characterised by market fundamentalism and finance fetishism. The crisis has now allowed a long overdue pushback to these developments, a pushback that would otherwise have been derided as Luddite and dirigiste. It is not that finance is unimportant or that markets should be spurned. It is rather that the i­nfluential devotees of finance and markets need to heed Talleyrand’s wise counsel: “Above all, not too much zeal”. january 10, 2009  EPW   Economic & Political Weekly